Management Notes

Reference Notes for Management

Inflationary gap said to exist when

Inflationary gap said to exist when

    1. Real GDP >Potential GDP
    2. Real GDP <Potential GDP
    3. Real GDP= Potential GDP
    4. Unemployment rate> natural rate of unemployment

Correct answer: Real GDP >Potential GDP

 Answer Explanation

The concept of an inflationary gap is one of the most important elements of macroeconomics. It describes the imbalance between the real output of an economy and its potential output. Option (a), “Real GDP > Potential GDP,” accurately identifies when an inflationary gap occurs.

An inflationary gap occurs when the Real GDP exceeds the Potential GDP of an economy. Inflationary pressures are prevented by the maximum sustainable level of output that an economy can achieve without generating excessive inflationary pressures. Real GDP represents actual output and income produced in an economy.

An economy with an inflationary gap indicates that it operates beyond its long-term productive capacity. This situation can lead to upward pressure on prices as demand exceeds supply, potentially contributing to inflation. A number of factors contribute to the emergence of an inflationary gap, including:

Excessive Aggregate Demand:

The economy’s capacity to produce goods and services can be exceeded when aggregate demand (the total spending in the economy) is exceptional. Increased consumer spending, government expenditures, or investment activity can lead to this demand-driven scenario.

Supply Constraints

The economy may be confronted with temporary supply-side disruptions, such as shortages of raw materials, labor, or inputs. These constraints limit the economy’s ability to meet demand.

Why the other options are not correct

b. Real GDP < Potential GDP:

This option is not indicative of inflation. Instead, it indicates that an economy is operating below its potential, resulting in a recessionary situation. Consequently, there may be a drop in prices and unemployment in this scenario if there is an excess supply of goods and services compared to demand.

c. Real GDP = Potential GDP:

When real GDP equals potential GDP, the economy is at full employment and its productive capacity, which means there is no inflationary or recessionary gap. There are no excess demands or supply pressures in the economy, and the economy’s long-term potential is aligned with economic activity.

d. Unemployment rate > natural rate of unemployment:

This option addresses the concept of a recessionary gap instead of an inflationary gap. Recessionary gaps occur when the unemployment rate exceeds the natural rate, which indicates that labor resources are being underutilized and there is a risk of deflation or inflation.


An economy that has an inflationary gap, as indicated by Real GDP exceeding Potential GDP, is operating beyond its sustainable capacity. As a result of this imbalance between aggregate demand and supply, prices may rise, potentially contributing to inflation.

The inflationary gap should be understood by policymakers and economists to formulate appropriate measures to maintain price stability and sustain economic growth.

Which of the following is phenomenon that leads to Hyperinflation?

Bibisha Shiwakoti

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